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Fed says Go..Go..Go!

Just when everything seemed to be going wrong for the US stock markets, the Fed has come to the rescue. In an unexpected move the Fed cut benchmark rates (0.50% - 0.25%), giving a sharp lift to the markets.

The Fed's move comes amidst rising concerns that the US economy was slowing very fast. The possibility of a hard landing i.e. recession was also not ruled out. Indeed, the bond markets had already factored in a rate cut by the Fed. The actual rate cut ranged from 0.50% for the federal funds rate and 0.25% for the discount rate.

How will the decline in interest rate help the US economy fight off the possibility of a recession? First, let's look from the point of view of consumers. For them the cost of money reduces, and as a result, buying goods on credit becomes much cheaper. This lifts demand for goods and services in an economy. When this happens (and this takes us to the company front), companies, which also benefit from lower interest rates, witness a general rise in profitability. As a result they employ more people and pay them better salaries. This in turn contributes to the purchasing power of the economy. Also, businesses invest in new capacity to be able to cope up with this rise in demand. This creates further employment and income for the consuming class.

This rise in demand and consequently profitability then drives interest in the stock markets.

Interest rates also have a more direct impact on stocks. First, with lower rates, the cost of investing in the markets reduces. As a result, more investors are more willing to go long on stocks. Second, as interest rates reduce, expectations of returns from stocks too get corrected. Therefore, given the same price level in the stock markets, a decline in interest rates, will imply a relatively more attractive valuation.

The Fed has once again reinforced the belief that in case something were to go wrong with the stock markets, they would be there to cushion the impact. Indeed, their move has had the desired impact.

Indian markets too will benefit from the 'largesse' of the Fed. Indeed, Indian ADRs have witnessed a sharp appreciation and this will buoy sentiment in the domestic markets.

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